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How to Make Money in Real Estate in the New Economy
How to Make Money in Real Estate in the New Economy
How to Make Money in Real Estate in the New Economy
How to Make Money in Real Estate in the New Economy
How to Make Money in Real Estate in the New Economy
How to Make Money in Real Estate in the New Economy
How to Make Money in Real Estate in the New Economy
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How to Make Money in Real Estate in the New Economy

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Excerpt: Chapter One - Understanding the Housing Crisis

Excerpt: Chapter One - Understanding the Housing Crisis

Published in: Real Estate
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  • 1. 1Understanding theHousing CrisisI t was a hot, humid day in Miami, Florida. I was running a few minutes late, so I quickly knocked on the door of unit 205. A gentleman inhis early seventies greeted me and politely asked, “Sr. Martinez, comoestás?” His facial features, mannerisms, and tone exuded experience—aman who had spent decades in the real estate trenches, a veteran whohad survived numerous downturns and volatile market cycles over thepast 50-plus years. I remember telling myself, “This guy has probablyseen it all!” But I knew those profoundly deep wrinkles around his eyesweren’t caused solely by vocational stress; rather, they were indicative ofa man who enjoyed spending much of his free time navigating the water-ways from Biscayne Bay to the Florida Keys aboard multimillion-dollaryachts. In other words, this guy had worked hard for many decades buthad also managed to survive and financially prosper in this cutthroatbusiness. 3
  • 2. The Past Unfortunately, this particular day was different. Even a man with five decades of real estate experience had never experienced anything like the current market conditions. And that’s where this story begins. With a handshake still quite powerful for a man of his age, he greeted me and asked that I take a seat in his makeshift office—known as unit 205. “Matt, I’m telling you this is just bad luck. Seven months after we acquired this apartment complex and converted it to condos, we had 132 units (out of slightly more than 200 total units) under agreement. We would have been able to pay off all the outstanding loans after selling those condos. The remaining 80 units (assuming they were sold after the first phase of sales) represented pure profit. In all my years in this business, I’ve never seen a market change so quickly. It simply fell off a cliff. Even if we were able to find willing and able buyers, they simply can’t get the required financing nowadays. The credit markets have all dried up. It’s a disaster, and we’re bleeding more than $12,000 a day! We haven’t paid the mortgage on the property in four months; the complex is only 50 percent occupied, and our loan officer has flagged our file and transferred it to the special assets department at the bank. Believe it or not, this was our very last project. My business partner and I were going to retire after this one. Matt, can you help us?” This is just one example from dozens of similar conversations I’ve had with developers since 2007. The range of financial and psychological “pain” spanned the full spectrum, but the ominous undertones always remained the same. With the housing market in a free fall, property own- ers, investors, speculators, and developers were left struggling under highly leveraged mortgages they couldn’t afford, given that their proper- ties were no longer worth what they had originally paid for them. As the amount of nonperforming loans escalated, lenders began to falter under the weight of too much bad debt. This chain of events served as a catalyst for the global financial crisis that began in 2008. The subprime mortgage debacle, subsequent credit crunch, finan- cial meltdown, and global recession have not only decimated investors’4
  • 3. Understanding the Housing Crisiswealth but have forever altered the landscape of real estate investing aswe know it. Heavy mortgage losses forced banks to immediately restrictlending, which caused real estate sales volumes to precipitously drop asprospective buyers, investors, and even speculators awaited the bottomof the market before they would consider reentry. The credit crisis, ensuing recession, and double-digit unemploy-ment dragged real estate markets into the worst recession we’ve seen indecades. Property value losses, rising foreclosures, higher vacancies, andrestricted capital markets are the norm and not the exception these days.Without a doubt, we are experiencing troubled economic times for allreal estate investors who overpaid, overleveraged, and didn’t anticipatethe fall.Government’s RoleThe housing crisis was exacerbated by the government’s role inencouraging home buying. In fact, the American dream demandedhome ownership, and the federal government was in the business ofmaking those dreams possible. American citizens were led to believethat they would not achieve that dream without home ownership.One of the primary goals of both the Clinton and Bush II administra-tions was to dramatically increase the rate of homeownership in ourcountry. The government-sponsored entities (GSEs), including FannieMae and Freddie Mac, were told to expand the number of home loansto low-income individuals—otherwise known as subprime borrowers.Individuals who really could not afford the costs of a house were sud-denly able to buy much more than they could handle. Access to cheap,easy money made it possible for millions of renters to become propertyowners. This experiment led to the subprime mortgage crisis. During the winter of 2008, I met with Congressman Barney Frank,chairman of the House Financial Services Committee, in his local officein Massachusetts. We discussed the economic and housing crisis, and 5
  • 4. The Past what needed to be done. He declared his strong support for affordable housing (he always had been a staunch advocate for providing more affordable housing), but also expressed his opinion that millions of fami- lies should have continued renting and that it should not be the govern- ment’s goal to encourage homeownership to those who cannot afford it. Rep. Frank said, “Not everyone should be a homeowner. In fact, there are a lot of people who should have remained renters.” Collateralized Mortgage Obligations (CMOs) By 2001, the dot-com bubble imploded, and investors fled the tech market in droves. They considered real estate a safer place to invest, so billions of dollars were diverted to real estate investment vehicles. Investment banks created collateralized mortgage obligations (CMOs) to capture these investment dollars. CMOs are a type of mortgage-backed security (MBS) whereby bonds (sold to investors) represent claims to the cash flows from pools of mortgages. They essentially served as a means to securitize large amounts of mortgages so investors could purchase them and fund the boom. With increased demand for CMOs, lenders reduced their lending standards, and the subprime market flourished. Investment banks were enamored of CMOs, and they invested billions. However, when prop- erty owners—under the heavy weight of their loans—began to default, investment banks, local and regional banks, and other financial institu- tions quickly shuttered. These events led to a national financial crisis not experienced in the modern era. Appreciating Values Before the crash, most property owners expected the appreciation of their properties to continue unabated and that double-digit annual increases would last forever. Interest rates remained extremely low after the tech6
  • 5. Understanding the Housing Crisisimplosion, so debt was affordable. Lenders began to market exotic mort-gages such as negative amortization loans (pay the minimum required, andthe principal could increase). Credit was plentiful, and NINJA (no income,no job, no assets) loans were common. Exotic loans to subprime borrowers(people who had poor credit) were regularly approved, but everyone knewthey couldn’t sustain the heavy debt burden indefinitely. In other words,almost anyone could and did get a mortgage to buy real estate that he orshe could not afford. Waiters, for example, who were making $30,000 a yearwere buying $1.5 million condos! Appraisers worked closely with mortgage brokers and lenders toensure that property values were in line with the sales price. Values wererising so quickly that no one could really estimate true market value.Most lenders just sold their portfolios of loans to the secondary market,so there was little risk. If they made the loan, they’d collect their fee fromthe borrower, earn additional fees from selling the loan to the second-ary market, and have zero risk on their balance sheet. It was the perfectscenario for housing arbitrage, and our country’s finest minds workingat our most prestigious financial institutions made a fortune. Homeowners leveraged their property’s equity by extracting everypenny out of it through home equity loans. They used the additionalcapital on spending sprees that included expensive cars, vacation homes,exotic travel, sophisticated electronics, and so on. Eventually, real estatevalues stopped going up, and homeowners found themselves left withmultiple loans on properties that were not worth what they owed onthem. They were left with negative equity and little incentive to continuepaying the mortgage.Today’s EnvironmentProperty values have declined significantly since the bubble burst. Manyproperty owners owe more on their homes than they are currentlyworth. With stricter lending practices adopted by banks, homeowners 7
  • 6. The Past are unable to refinance their properties to 30-year fixed rates because they are under water with no residual equity remaining. Banks won’t lend more than the real estate is worth, so a lot of property owners find themselves between the proverbial rock and a hard place. The investing strategies practiced just a few years ago (during the boom years) are now terribly inadequate for succeeding in today’s distressed real estate market. Investors need to think and act differently if they want to survive this down cycle and profit when the economy eventually rebounds. While fully recognizing the mistakes of the past and providing sound advice for taking advantage of future opportunities, this book explains how to successfully invest in today’s distressed market. Recent developments have crushed many real estate speculators, but they have also created profitable new opportunities for individuals willing to serve as the next generation of contrarian investors—a generation that will undoubtedly make their fortunes by buying when everyone else is desperately selling. This book offers effective strategies for taking advantage of this new era of investing. Though most of yester- day’s most favored strategies no longer work, today’s savvy real estate investors can still find great opportunities for growth and profit—if, of course, they acknowledge how recent events are altering the real estate landscape and if they determine how to take full advantage of the situation. Investors must return to the sound fundamentals that have worked for centuries. It’s back to “blocking and tackling” and doing what has consistently worked in the past—buying on cash flow and disregarding the notion of automatic price appreciation. Increases in value during this tough cycle will be dependent on your property’s Net Operating Income. You can’t do much about the economy, so you must add value. Buying at distressed and greatly depreciated prices is a good start. If you’re going to make money in real estate during these challenging times—you’ll have to earn it the hard way!8
  • 7. Understanding the Housing CrisisWhat’s to Come Next?A reset has occurred in our new economy. Real estate values will resetlower. Deleveraging is taking place. Debt-to-equity ratios will becomemore manageable. Only people with very good credit will have accessto new loans, but they’ll need to put significantly more money downto buy. Real estate investors should expect a wave of foreclosures on over-leveraged properties to continue during this year. That being said,I anticipate single-family homes and rental apartments to be on theforefront of a recovery. A reduction in construction will limit supplywhile demand rises because of immigration, retiring baby boomers, and80 million echo boomers leaving college to enter the workforce (moreon that later in the book). Office and retail will falter from 2011 to 2012.But, once again, tremendous financial opportunity can always be foundduring distressed cycles. In the postcrisis landscape, success in real estate will be defined byan unwavering concentration on the fundamentals—valuing propertiesbased on their existing merits coupled with a realistic approach to deter-mining both the current and future financial potential of a given asset. 9

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